Tax Planning: Foreign exchange fluctuations and tax treatment

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This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on March 20 - 26, 2017.

 

This article attempts to promote a basic understanding of the effects of fluctuating foreign exchange (forex) rates in the context of the Malaysian Financial Reporting Standard 121 — Effects of Changes in Foreign Exchange Rates (MFRS 121), which has been in force since 2006. We will then try to fathom the tax treatment of forex gains and losses against the backdrop of the declining ringgit. 

At the outset, I should provide a caveat that I am not competent in the interpretation and application of MFRS 121 in particular and financial reporting standards in general. In this article, I am approaching the subject matter from a tax perspective.

 

TERMINOLOGY 

First, let us establish the meaning of the terms used in relation to forex.

 

Functional currency, presentation currency and foreign currency

For illustrative purposes, let us have Company A, which is incorporated in Malaysia, is engaged in manufacturing and exports to the global market. Under MFRS 121, the company may have different currencies determined as functional currency, presentation currency and foreign currency. 

Functional currency is the primary currency used in driving the entity’s operations. It is not necessarily determined by the location of operations or the currency its transactions are denominated in. It is the currency that determines and influences sale prices and operating costs. For instance, Company A’s exports are mainly driven by the US dollar. Therefore, its functional currency is the US dollar. 

The presentation currency is used in the presentation of the company’s financial statements. In Malaysia, under the Companies Act, it is compulsory to have the ringgit as the presentation currency. Thus, Company A’s presentation currency is the ringgit.

Foreign currency is any currency other than the functional currency. Company A sometimes transacts business in the renminbi, so it is identified as foreign currency.

 

Translation

Translation is the act of expressing the value of a transaction or asset in another currency. Translation is normally done at the financial year end when the outstanding balances are translated into the presentation currency. 

For instance, Company A paid US$100 on Nov 1, 2016, for a service. At the time, the exchange rate was RM4 to the US dollar. Therefore, the cost of the service was RM400. At year end, the company needs to translate the amount (which has not been settled) into its presentation currency at the prevailing rate, which has risen to, say, RM4.2 to the US dollar. An exchange loss of RM20 (RM420 - RM400) is said to have arisen on translation.

 

Conversion 

Conversion refers to the actual settlement of the transaction amount in another currency, leading to the crystallisation of the difference in exchange rates. In the above example, the US$100 was paid on Jan 10, 2017. On the settlement date, the exchange rate was RM4.35 to the US dollar. An exchange loss of RM35 (RM435 - RM400) is said to have arisen on conversion.

 

Realised, not realised

The differences in translation are not considered realised while the differences in conversion are said to be realised.

 

Trade and capital transactions

A trade transaction is one that involves inventories and revenue transactions such as remuneration, services, rental or lease of equipment used in the production of goods sold or services provided. A capital transaction is related to non-current tangible and intangible assets (fixed assets) of the business such as plant and machinery, equipment, vehicles, land and factory, patents and software.

 

FINANCIAL REPORTING

Today, I read this in the business section of the newspapers:

“XXX Bhd registered a sharp decline in earnings for the last three months of 2016, as the decline in the value of the ringgit resulted in foreign currency translation losses. The company saw its net profit fall 95% to RM15 million for the second quarter of its financial year ended Dec 31, 2016, compared with RM700 million in the previous corresponding quarter.”

The alarming drop in the profit of this company appears to have been mainly caused by a foreign currency translation loss. This demonstrates the tremendous impact forex losses or gains have on the bottom line of an enterprise.

The use of the word “translation” in the news report is significant, as we will see in the discussion of the tax treatment below.

 

TAX TREATMENT — GUIDELINES ISSUED

Very briefly, MFRS 121 requires enterprises to translate the functional and foreign currencies into the presentation currency on transaction dates and the financial year end. This leads to the reporting of a much higher incidence of forex losses and gains in financial statements. 

Significantly, it also leads to a divergence between the accounting treatment and tax treatment, which requires further adjustments and considerable reconciliation for tax purposes. The underlying tax principle has hitherto been a two-step approach.

 

Step 1: Did the forex gain or loss arise out of a trade transaction? If yes, the gain or loss is revenue in nature. Go to Step 2. If no, the gain or loss is capital in nature. No more tax considerations.

 

Step 2: Is the gain or loss realised? If yes, the gain or loss is taxable or tax deductible. Only a gain or loss on conversion is considered as realised. A loss on translation is not realised for tax purposes and is disregarded. If no, the gain or loss is not taxable or tax deductible until it is realised.

In response to the implementation of MFRS 121, the Inland Revenue Board (IRB) issued guidelines dated July 24, 2015, to explain the tax treatment of forex gains and losses. As the subject matter is intrinsically complex, the contents of the guidelines may not be easily grasped. Generally, the erstwhile tax principle remains intact, but there are some modifications. 

IRB requires that the spot exchange rate on the transaction date be applied to record the transaction amount. This is in line with the accrual concept of recognising business income. When the amount is settled, the exchange rate on that date is taken to compute the forex gain or loss. 

 

Example

Company A (financial year end Dec 31) issued an invoice for an export valued at US$100 on Oct 1, 2016. The spot rate on that date was RM3.80 to the US dollar. On Dec 31, 2016, the rate was RM4.30. On Feb 1, 2017, the company received US$100, which was converted at the prevailing rate of RM4.50.

 

The tax treatment is as follows:

1. The sum of RM380 should be recognised as gross revenue from sales in the year of assessment (YA) 2016 because the export is a trade transaction. 

 

2. A translation gain of RM50 (RM430 - RM380) is to be recorded in the financial statements for the year ended Dec 31, 2016. This gain is disregarded for tax purposes in YA2016 because it was not realised.

 

3. In YA2017, the gain of RM70 (RM450 - RM380) is recognised as income because it has been realised.

 

Additionally, the IRB takes into account whether the receipt or payment of the amount is effected through a foreign currency account with a bank in Malaysia. The said foreign currency account is maintained by many companies to act as a natural hedge against currency fluctuations. 

 

Example 

The facts are as above, except that Company A maintains a US dollar account with a bank in Malaysia and the US$100 is received through the account. The company also receives other US dollar amounts and makes US dollar payments through this account.

 

According to the IRB’s guidelines, the tax treatment is as follows:

1. The sum of RM380 should be recognised as gross revenue from sales in YA2016 because the export is a trade transaction. 

 

2. A translation gain of RM50 (RM430 -RM380) is to be recorded in the financial statements for the year ended Dec 31, 2016. This gain is disregarded for tax purposes in YA2016 because it was not realised.

 

3. In YA2017, when the amount of US$100 is received through the US dollar account, the gain is treated as not realised. The gain of RM70 (RM450 - RM380) is disregarded, that is, not taxable.

 

At this point, I would like to go back to the news report on XXX Bhd. The forex losses on translation mentioned in the report will not be recognised for tax purposes because they are deemed not realised. Oh dear!

 

CAPITAL TRANSACTIONS

If a transaction is capital in nature — say, a fixed asset is acquired for the business and the asset is eligible for capital allowance — any realised forex gain or loss will decrease or increase the amount of capital expenditure used in the computation of the capital allowance. 

 

Example

Company A purchased machinery for US$1,000 on Aug 15, 2016. The spot exchange rate on the transaction date was RM3.60. On Dec 15, 2016, the company fully settled the US$1,000 at the prevailing exchange rate of RM4.45.

 

The tax treatment is as follows:

1. As the transaction is capital in nature and the machinery is used in the manufacturing business, the cost of RM3,600 (US$1,000 x 3.60) is the qualifying plant expenditure (QPE), based on which the capital allowance is written off and deducted against adjusted income from the manufacturing business.

 

2. When RM4,450 (US$1,000 x 4.45) was paid on Dec 15, 2016, the exchange loss of RM850 (RM4,450 - RM3,600) may be added on to the cost of the machinery to bring the total to RM4,450 (RM3,600 + RM850) as the QPE qualifies for capital allowance in YA2016. 

 

However, if the payment of US$1,000 is effected through the company’s US dollar account, the QPE remains at RM3,600.

 

This article does not purport to be instructive or anywhere near exhaustive. It merely hopes to highlight that forex gains and losses must be closely monitored and the relevant spot exchange rate duly recorded. This contemporaneous action will greatly facilitate the necessary tax adjustments when preparing the annual tax computation. 


Yong Siew Chuen has wide experience in Malaysian taxation. She now focuses on tax training and coaching. Comments: [email protected].